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Merrill Lynch Analyst Raises 2005 Commodity, EPS Estimates

With May natural gas futures prices comfortably trading above $7/MMBtu, some analysts and investment houses are revising some of their projections for the energy industry in 2005. Last week, analysts with Merrill Lynch released their latest commentary, in which they revised commodity price estimates as well as exploration and production (E&P) company earnings estimates.

Based on the current elevated market conditions, the company said it is increasing its 1Q2005 average natural gas Henry Hub price projection from $5.95/MMBtu to $6.40/MMBtu. Likewise, for full year 2005, Merrill Lynch bumped its estimate from $5.75/MMBtu to $5.86/MMBtu. Lehman Brothers raised the natural gas price forecast by $0.25-1.00, to range between $6.00 and $6.25/MMBtu.

"Our commodity price forecasts remain somewhat below the Street, which has a more aggressive view on demand growth and supply/demand balance," said John P. Herrlin Jr., first vice president with Merrill Lynch. "Inventory levels, in our view, are ample. We expect more stock price volatility, and think 1Q2005 [will] be a peak."

Last month, Lehman Brothers upped its estimates as well (see NGI, March 14). The investment firm said E&P companies may see 2005-2006 cash flow estimates 10-30% higher, with the average target upside about 10%. Lehman Brothers raised the natural gas price forecast by $0.25-1.00, to range between $6.00 and $6.25/MMBtu.

The Merrill Lynch analyst noted that most E&Ps and integrateds bested Street expectations for earnings and cash flow in 2004, more so in the first three quarters than the last. Year-to-date, Herrlin said the average E&P company's earnings per share (EPS) is up 18.5%, while the average U.S.-based integrated company's EPS is up 17.8%. This compares to a 24.4% rise in oil prices and a 13.8% increase in Henry Hub natural gas. He noted that year-to-date EPS gains are almost three-quarters of that of all of the last calendar year. Given the strong commodity price gains, the analyst raised 1Q2005 EPS estimates by 11.2% for integrateds and 16.2% for E&Ps.

"Overall, the stocks (E&P and integrateds) have moved in a manner proportionate to the underlying commodities or in response to other catalysts, i.e., takeover speculation," Herrlin said. "At issue will be the strength in demand and timing of seasonal commodity price drops and the market's perception to that change. We still view much of the recent stock and commodity price activity as having been very momentum-driven."

Because of the high degree of institutional ownership and strong performance levels, the analyst said he believes on a short-term basis that the E&Ps are peaking, which is why Merrill Lynch is "neutral for the most part" after having rated several stocks previously as multiyear buys. He added that Merrill Lynch would have had to believe in multiple expansion, higher average prices long term, or mergers and acquisitions to sustain its ratings.

"At this stage, many believe in the higher and longer view on commodity pricing beyond our current price forecasts," he said. "We prefer to err on the side of conservatism and continue to believe that this industry remains cyclical, and are concerned about the U.S. dollar, U.S. trade imbalances and U.S. consumer spending.

"Current Street school of thought reminds us of other times where downside wasn't apparent," Herrlin added. "We do believe that upstream spending will stay high, and that operating cost creep will remain an issue, which will get more focus when wellhead prices normalize at lower levels. So, we've positioned our coverage list defensively, emphasizing integrateds."

The analyst noted that in the longer term he does expect more industry consolidation. However, he said "it may not be a near term reality. If it was, there probably wouldn't have been $1.2B in YTD insider selling across all energy sectors just since the start of the year."

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